As international people living in Spain, no matter how much we integrate, we still do not have the experience acquired over generations of how systems work, and what the cultural norms mean for day to day life.
Nowhere is this clearer than when it comes to our financial planning and tax issues. Whilst the last 11 years have seen my knowledge and understanding improve to a very high level, all we international people who live in Spain are in the same boat; and it´s about to be buffeted by the Brexit winds.
It is therefore reassuring to know that there is one aspect of providing for ourselves and our families that is consistent. This is the importance of dividends in our financial planning.
Dividends are an important part of your planning, whether you are investing for income or investing for capital growth. As an income, they can increase over the years and help to offset the impact of inflation. For capital growth, the re-investment of the dividends gives rise to the magic which is compound interest. Here we look at both uses and how they should be an important part of your planning.
A Simple Guide to Dividends
When a company makes a profit, part of the profit can be used to pay off debt, invest in new technologies, give bonuses to their staff and many more options. However, one option is to “pay” or reward the shareholders for having invested in the company. This payment to the shareholders is called a dividend. It is often paid twice a year with an interim, which is the smaller part, and a final dividend. ´Dividend´ is expressed as “a percentage of the current share price”, so that comparisons can be made between companies with different share prices and in different sectors.
The dividend is an important measure for investors and therefore a board of directors treats it as one of the most important financial aspects of their business. Neil Woodford, probably one of the world’s best income fund managers, recently made this comment:
“Companies find it very hard to cut their dividends. It is the walk of shame for any board and executive management to cut the dividend – it is a last resort, and rightly so. By contrast, companies that choose to sustain and grow their dividends, are doing so in the knowledge that they are creating a bigger burden for the future – they need to be confident in the sustainability of the business and its future growth prospects, in order to do so.”
So let us consider an example of how dividends work as a way of providing income. Let us start by explaining how the % aspect works.
If the dividend is 4p for every share held and the price of the share or the unit is 100p, then the dividend is quoted as 4%. Much is made of this figure. “Ten Top Dividend Paying Shares” is a headline often seen in the papers.
Yet what this is really saying is that this year, the shares will receive 4p per share. If the company does well and is able to raise the dividend next year the dividend will change.
For us, we have purchased at 100p per share. So if the dividend is raised to 4.5p per share next year OUR dividend yield has increased to 4.5%. In 15 years if the dividend is 12p OUR yield is then 12%. This is because our return is based on the purchase price.
In the current low interest rate environment, this is a great way to build the return on your investments. Slowly but surely, possibly with some ups and downs on the way, this is an excellent method of increasing your income.
Now let’s examine the capital value of the shares. If the norm for dividends for this type of company is 4% per share, the share price will react to the change of dividend. Let´s assume in 15 years time the dividend is 12p. The capital price will be based upon:
Share Price *4% = 12p
Share price = 300p
As the dividend yield is still quoted as 4%, you could be mistaken for thinking that the dividend has not changed, however, as you only paid the 100p, the income is good and the share has increased in value.
Of course, this is a simplified example. The sustainability of the dividend, the dividend cover, the prospects for the company, the new product stream and much, much more all have to be taken into account, but fortunately there are companies and managers that specialise in this specific type of assessment.
We have seen the impact on the share price in the example above – but, if we have the dividend re-invested into the fund instead of taking the dividends, this has the effect of providing compound interest.
A way in which this is particularly beneficial is to offset the fact that we will all be living longer. For example, if you retire at 55, on current data, your money has to last 31 years and if your retire at 65, your money has to last 33 years. You can see from the graph that using dividends as a way to build your capital is an important part of the strategy to make your money last.
Here is what this looks like:
Taken from Woodfordfunds.com
For putting into practice the principles in this article, please feel welcome to contact me directly.